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Relying on the foregoing regulations, respondent determined that
the flooring materials that Smith Floors purchased and installed
during 1995 were merchandise, that such merchandise was an
income-producing factor, and that Smith Floors therefore must use
the accrual method of accounting to clearly reflect its income.
Petitioners contend that Smith Floors is a service provider
and that it purchases flooring materials solely as an
accommodation to those contracting for its services. Therefore,
petitioners contend that Smith Floors’ use of the cash method of
accounting is proper.
Whether Smith Floors must use the accrual method of
accounting instead of the cash method depends on whether Smith
Floors is in the business of selling merchandise (within the
meaning of sec. 1.471-1, Income Tax Regs.) to customers in
addition to providing flooring installation services or whether
the flooring material provided by Smith Floors is a supply that
is incidental to Smith Floors installation services.
The term “merchandise” is not defined in either the Internal
Revenue Code or the regulations. See RACMP Enters., Inc. v.
Commissioner, 114 T.C. 211, 221 (2000). To resolve whether
particular materials constitute merchandise, we look to the
context in which the materials are used. See id. The high cost
of materials relative to labor costs is insufficient, standing
alone, to transform the sale of a service to the sale of
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